Waddell & Reed Shows Long-Term Investor Can Unhinge Wall Street

By Christopher Condon -
Oct 1, 2010

Waddell & Reed Financial Inc., the
mutual-fund manager based in the heart of Kansas that caters to
mom and pop investors, is an unlikely company to be blamed for
sending Wall Street into a tailspin on May 6.

“They’re a long-term, buy-and-hold investor,” Geoff Bobroff, a fund-industry consultant in East Greenwich, Rhode
Island, said in a telephone interview. “Their nature is not of
an organization that is an active trader.”

The automatic execution of a sale order on a large block of
futures with no regard for price helped trigger the May 6 stock
market crash, which snowballed into an $862 billion rout,
regulators said in a report released today. Waddell & Reed,
which manages about $68 billion, was the seller, said two people
with direct knowledge of the report, which doesn’t name the
firm.

“One key lesson is that under stressed market conditions,
the automated execution of a large sell order can trigger
extreme price movements, especially if the automated execution
algorithm does not take prices into account,” according to the
report from the U.S. Securities and Exchange Commission and
Commodity Futures Trading Commission.

Hedging Strategy

The company, started 73 years ago by Cameron Reed and
Chauncey Waddell, was unloading Standard & Poor’s 500 Index
futures, known as E-minis, in the course of normal hedging of
its holdings, according to the report. The trading may not have
prompted a retreat had investors not already been rattled by
negative news, including a worsening of the European debt
crisis, said the people.

Waddell said it sold 75,000 E-mini contracts, or 1 percent
of overall trading volume in the derivative on May 6, according
to a statement from the company.

“We believe we were one of 250 firms engaging in E-mini
trading during the period of the market selloff,” the company
said in the question-and-answer-style statement first released
in May. “We believe that trades of the size we
initiated normally are absorbed easily in the market.”

Roger Hoadley, a spokesman for the Overland Park-based
company, said the statement was “still accurate and relevant.”

SEC Chairman Mary Schapiro asked the agency last month to
examine whether the loss of traditional market makers has hurt
investors. With market making now dominated by hundreds of
automated traders with few rules for when they must buy and
sell, the SEC will consider ways to keep the biggest from
abandoning the market at the first sign of trouble.

High-Frequency Firms

After the May crash, U.S. lawmakers including Senator Ted Kaufman, a Democrat from Delaware, asked if the high-frequency
firms that have supplanted specialists and market makers with
strategies that transact thousands of shares a second
destabilized trading by stepping away when they were needed
most.

Waddell & Reed, started with less than $125,000 in assets
during the Great Depression, is the opposite of a high-speed
trader. Like most mutual-fund firms, it holds onto its
investments for months or years. Like other firms, it trades
futures to minimize losses from unexpected market fluctuations.

The firm is small compared with the largest fund managers.
Vanguard Group Inc., based in Valley Forge, Pennsylvania, is the
biggest U.S. mutual-fund manager by assets, with $1.31 trillion.
Fourteen individual U.S. mutual funds hold more assets than
Waddell & Reed, according to Bloomberg data.

Waddell & Reed, which went public in 1998, fell 10 percent
this year through yesterday, compared with the 4.1 percent
decline by the Standard & Poor’s index of asset managers and
custody banks. Its market value is $2.3 billion, compared with
$32.6 billion for New York-based BlackRock Inc., the biggest
publicly traded money manager.

Not Ideal PR

Jeffrey Hopson, an analyst at Stifel Nicolaus & Co. in St.
Louis, said the report is unlikely to damage the company in the
long term.

“It’s not ideal PR, but the activity didn’t represent
anything unusual,” Hopson said in a telephone interview.

Bobroff, the consultant, said Waddell’s distribution
structure will help protect it from any reputational fallout
with individual investors. The company sells to individual
investors almost exclusively through intermediaries, including
its own network of financial advisers, who have a direct
relationship with their clients.

Waddell & Reed is run by Henry J. Herrmann, a 39-year
veteran of the company who became chief executive officer in
2005 and added the post of chairman in January. Herrmann, 67,
joined the firm as an analyst and served as a fund manager and
chief investment officer.

Fund Returns

The $21.4 billion Ivy Asset Strategy Fund, the company’s
largest, has returned 2.2 percent this year, worse than 89
percent of rival funds, according to data compiled by Bloomberg.
The fund, which can invest in stocks, bonds and short-term
securities, has outperformed 99 percent of competitors over the
past five years, returning an annual average of 10 percent.

In the past five years, the Waddell & Reed owned funds,
including the Ivy fund series, that invest in both stocks and
bonds beat 86 percent of U.S. fund companies in that category,
according to Chicago-based research firm Morningstar Inc.
Waddell’s taxable bond funds topped 41 percent of competing fund
families. Its domestic and international stock funds ranked
ahead of 63 percent and 49 percent of rival companies.

Waddell was one of several mutual-fund companies that
settled claims by the SEC earlier this decade. The company paid
$77 million in 2006 to resolve accusations that it allowed
certain clients to make improper trades.